China's fuel subsidy costs the world

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(Wei Gu is a Reuters columnist. The opinions expressed are her own)

Vehicles line up for diesel at a gas station in Baokang, Hubei province April 30, 2008. REUTERS/Stringer

By Wei Gu

HONG KONG (Reuters) - Buckling under the weight of record oil prices, a slew of Asian countries have cut or are thinking of cutting their fuel subsidies, which raises a pressing question for Beijing: Can China afford its own oil subsidies at a time when it is spending billions on post-earthquake reconstruction?

The short answer is yes, because China is blessed with both large trade account and fiscal surpluses. The reconstruction cost is projected to amount to about 1 percent of China’s gross domestic product, while the fuel subsidies account for another 1 percent, JP Morgan estimates.

Remember that China had a fiscal surplus of 0.7 percent of GDP last year, or $174 billion. So even if spending on post-earthquake rebuilding and fuel subsidies were to cause a 1 percent fiscal deficit, that would still be very manageable.

But here’s a more important question: Why should China keep domestic fuel prices at about half of the global average?

The usual answers are to keep inflation in check and stave off social instability that could result if prices were to rise too quickly.

But by distorting fuel prices, China is encouraging fuel consumption and discouraging the use of new energy. Since the Chinese still live in an $80 per barrel oil environment, demand for anything from cars to chemical products will spiral higher and raise the risks of economic overheating.

Increasing subsidies on fuel will crowd out more investment in other areas, such as education or health care, to name two possibilities.

What’s more, a worsening fiscal situation might put downward pressure on the yuan. Fuel subsidies have exaggerated inflation in the developed world, while understating inflation in the developing world. China’s inflation could well hit 15 percent if Beijing were to free up caps on energy prices, Morgan Stanley estimates.

“If China is not able to take away the subsidy and cut down its demand, it will have huge implications for the world,” said Shikha Jha, a senior economist at Asian Development Bank.

Countries such as China, India and the Gulf nations, whose retail oil prices are kept below global prices, contributed 61 percent of the increase in global consumption of crude oil from 2000 to 2006, according to JP Morgan.

Other than Japan, Hong Kong, Singapore and South Korea, most Asian nations subsidize domestic fuel prices. The more countries subsidize them, the less likely high oil prices will have any affect in reducing overall demand, forcing governments in weaker financial situations to surrender first and stop their subsidies.

That’s what happened over the past two weeks. Indonesia, Taiwan, Sri Lanka, Bangladesh, India and Malaysia have either raised regulated fuel prices or pledged that they will.

Actions taken by those countries will not be able to tame a rally in prices though, unless China, the second-largest oil user in the world, changes its policy.

While the West is critical of China’s energy policy, there is little outcry for change within the country, except for complaints from two loss-making refineries.

By contrast, Indonesia has convinced its people that fuel subsidies benefit the rich more than the poor, because rich people drive more and consume more electricity. Jakarta rolled out a $1.5 billion cash subsidy program to help low-income Indonesians cope with higher prices. Although no countries want to build a system on subsidies, the cash subsidy at least makes fuel subsidy cuts politically feasible.

“The people need to wonder, who pays for the subsidies?” said Louis Vincent Gave, chief executive of research and asset management firm GaveKal. “Most Asian countries are printing money to pay for them.”

Fuel subsidies compromise countries’ ability to control their own budget spending. If China and India can cut their subsidies, they would be able to spend more on infrastructure and education.

While Asian governments dole out cheap food and energy, Asian currencies settle the bill. Morgan Stanley expects some emerging market currencies to face downward pressure, probably for the first time in a decade, as those countries unwind their fuel subsidies and domestic inflation shoots up.

China’s domestic fuel prices are among the lowest in the world, equal to about 61 percent of prices in the United States, 41 percent of Japan, and 28 percent of England. The longer it waits, the more painful it will be when it tries to remove the subsidy.

“Giving out subsidies is an easy and popular thing to do,” said Bill Belchere, an economist with Macquarie Securities. “But getting rid of it is like hell.”

(At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund.)